To default or not to default – that is the question


AS the markets focus once again on Greece’s ability to repay its debt, pop up in both Spanish and Italian yields a couple of weeks ago caught the markets by surprise and posed the question –‘Could Spain be the next bailout candidate?’

Spain has always been the canary in the coalmine and if it ever sought a bailout no type of rescue package would be big enough to save it – and if we did reach this stage then it’s highly likely the euro would simply have no further value as a currency.

Spain is fairly unique, as it’s governed by 17 autonomous communities alongside a decentralized government. Each one of these has its own budget and the markets concern is that central government still does not have a true handle on the debt exposure of these 17 communities.

The ‘hidden debt’ problem first popped up in Catalonia after elections last autumn resulted in Catalan nationalists unseating a Socialist-led coalition. In December, the central finance ministry said the region’s debt-to-regional-GDP ratio was 1.7% as of the third quarter. The old government later disclosed the full-year deficit could be as high as 3.3%.

May 22’s elections saw more socialist regional governments voted out of office and the real fear that more hidden debts could emerge. Spain has made great efforts in cutting its deficit to 9.3% of GDP, however much of this has come from centralized government cuts.

The huge glut of unsold homes and the billions in bad property loans still lie on the balance sheets of mainly provincial banks that have yet to still fully disclose their liabilities. Spain certainly has a challenge ahead of it and with youth unemployment the highest in Europe at 24% it’s clear that it has a generation that will have to make tough sacrifices and decisions.

Greece remains the problem that just won’t go away. If life was simple Greece should take a haircut on 50 per cent of its debt obligations and look to rebuild. However the risk of contagion would be far too great and this would spread to Portugal, Ireland, and even Spain. German banks would be forced to write off billions of euros and it would send the global economy back to the dark ages.

The solution the euro politicians have come up with is the term debt reprofiling. Put simply it would allow a country to roll over its debt obligations for a period of maybe 35 years. This would get round a technical default, that itself could trigger a wave of CDO claims as debt insurance would be triggered. As with anything in European politics nothing has yet to be decided but it’s clear the indebted southern nations can no longer devalue their currency, do not possess anything like the levels of growth needed to repay their debt and have reached levels of austerity that are no longer effective.

Sterling will remain under pressure as the UK economy looks like its hitting some turbulence as the consumer responds to the government’s tough austerity measures. It’s highly unlikely the Bank of England will hike rates in 2011 and the pound along with the dollar and euro will still be viewed as the 3 ugly sisters by the currency markets.



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